FOMC Preview: What to Expect from Yellen, Impact on Dollar

Currencies are trading quiet this morning ahead of the Federal Reserve’s monetary policy announcement. Central bank meetings are always important but investors across the financial markets are watching this one very closely for 2 reasons. It will be Janet Yellen’s first monetary policy meeting as Federal Reserve Chairwoman and what she says and does could set the tone for her leadership at the Fed. The central bank will also hold its quarterly press conference and release its latest economic projections, providing additional insight into their outlook for the economy. It has always been difficult for Bernanke to avoid moving the markets with his comments at the press conference and Yellen faces the same challenge.

Luckily, many of the major changes expected from the Fed today have been fully priced into the market. It is widely believed that the central bank will reduce asset purchases by another $10 billion and drop its unemployment rate threshold in favor of qualitative guidance. The Fed has the flexibility to continue removing stimulus because of the improvements in the labor market and consumer spending. As seen in the table below, retail sales turned positive in February after falling in January and payroll growth more than doubled last month. However, there are still areas of weakness. Inflationary pressures continue to ease, housing market activity has been mixed with manufacturing and service sector activity growing at a slower pace in February. This means Yellen will go out of her way to emphasize the central bank’s dovish monetary policy stance. She will remind everyone that even with today’s tapering, monetary policy remains extremely accommodative and rate hikes are not happening any time soon.

How Dollar Responds to FOMC Hinges on 2 Variables

If the market has already priced the big changes from the Fed, the U.S. dollar’s reaction to FOMC hinges on 2 variables

The first is what Qualitative Guidance looks like. When the Bank of England abandoned their unemployment threshold, they tied future policy tightening to the slack in the labor market. The current FOMC statement already contains some details on qualitative guidance. In the last statement, the central bank said other measures such as “labor market conditions, indicators of inflation pressure and inflation expectations and readings on financial developments,” will determine how long a highly accommodative monetary policy stance is maintained. If Yellen uses these indicators as measures of qualitative guidance, they will be specific enough for the market to understand that employment and inflation are the central bank’s primary focus and vague enough to provide no additional information on the timing of future rate hikes. If the central bank does not elaborate on these measures and simply ties forward guidance to what is currently in the FOMC statement, investors will be disappointed and the dollar’s reaction will be limited. For central banks comfortable with their current course of monetary policy, saying less could be doing more for the economy so this could be an ideal choice for Yellen. However if she chooses to be more transparent and provides more specifics or additional conditions, the dollar could have a more significant reaction.

The second will be the Federal Reserve’s latest economic projections. As these are hard numbers there is very little ambiguity. If the central bank lowers its 2014 GDP forecasts because of weak growth at the start of the year, investors could sell dollars if they interpret this to mean a more pessimistic outlook for the economy. If they leave their GDP forecast unchanged, it could be interpreted as a slightly more optimistic outlook for the rest of the year, which would be positive for the greenback. Their forecasts for the unemployment rate will also be lowered but we are not looking for any significant changes to the central bank’s inflation projections.

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